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Alliance Appraisal Services LLC Real Estate Appraisal Company |
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ALLIANCE APPRAISAL SERVICES LLC Cost segregation studies are conducted for a variety of reasons (e.g., income tax, financial accounting, insurance purposes, property tax). For income tax purposes, a cost segregation study involves the allocation (or reallocation) of the total cost (or value) of property into the appropriate property classes in order to compute depreciation deductions. The results of a study are typically summarized in an accompanying report, although there is no standard format for either the study or the report. The methodology utilized in allocating total project costs to various assets is critical to achieving an accurate cost segregation study. Some of the more common methodologies, and their potential drawbacks, are summarized below. THE MOST COMMON METHODOLOGIES UTILIZED FOR COST SEGREGATION STUDIES? The most common methodologies that are utilized in preparing cost segregation studies, are as follows: 1. Detailed Engineering Approach from Actual Cost Records The detailed engineering approach from actual cost records, or "detailed cost approach," uses costs from contemporaneous construction and accounting records. In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation. Construction-based documentation, such as blueprints, specifications, contracts, job reports, change orders, payment requests, and invoices, are used to determine unit costs. The use of actual cost records contributes to the overall accuracy of cost allocations, although issues may still arise as to the classification of specific assets. This approach is generally applied only to new construction, where detailed cost records are available. For used or acquired property and for new projects where original construction documents are not available, an alternative approach (e.g., the "detailed engineering cost estimate approach") may be more appropriate. The detailed cost approach is the most time consuming method and generally provides the most accurate Costs allocations. However, the examiner should recognize that the proper classification and costs of § 1245 properties could still be an issue with this method. 2. Detailed Engineering Cost Estimate Approach The detailed engineering cost estimate approach (or detailed estimate approach) is similar to the detailed cost approach. The difference is that the detailed estimate approach estimates costs, rather than using actual costs. This approach is used when cost records are not available or for an acquisition when the purchase price must be allocated. The detailed estimate approach is methodical, relying on solid documentation and utilizing construction-based documents such as blueprints, specifications, contracts, job reports, change orders, payment requests, invoices, appraisals, etc. When estimates are required, they are based on costing data, either from contractors or from reliable published sources (e.g., R. S. Means or Marshall Valuation Service). The sources of estimating data are clearly referenced, including identification of the specific volume, page, and item number. Further, the same estimating techniques and unit cost data sources are used for all of the items that comprise the actual cost. In essence, the steps for this approach are the same as the detailed cost approach, except for a prepare quantitative "take offs" for all materials and use payment records to compute costs. However, if detailed cost estimates are prepared by qualified individuals, and the estimates are reconciled to actual costs, then reasonably-accurate cost allocations are possible. 3. Survey of Letter Approach The surveyor letter approach is an alternative method for estimating costs. In this approach, contractors and subcontractors are contacted via a surveyor letter to provide information on the cost of specific assets that they installed on a particular project. These costs are then used in one of the engineering approaches or in the residual estimation approach (discussed in the following section). In situations where the contractor provides actual cost data, the allocations may be reasonably reliable. However, when contractor data is obtained from other sites or projects, the data may not be comparable or reliable. The amount of detail provided by different contractors may also vary. The wide disparity in cost estimation methods dictates the use of caution to ensure that the total allocated costs do not exceed the actual total project cost. 4. Residual Estimation Approach The residual estimation approach is an abbreviated method in which only short-lived asset costs (e.g., 5- or 7-year property) are determined. Short-lived asset costs are added together and then subtracted from the total project cost. The remaining or "residual" cost is then simply assigned to the building and/or other long-lived assets. Although this method is simpler and less time consuming than the engineering approaches, it can also be less accurate. It should be recognized that this method generally does not reconcile project costs. In general, residual costs are not estimated or checked for reasonableness. A proper and "reasonable" residual cost should always be determined and then added back to the total of all short-lived asset costs to check if the total project cost is reconciled. It should also be understood that different estimation techniques for short-lived assets can produce a skewed result in favor of § 1245 property (e.g., § 1245 property based on single unit costs for high quality construction, while the building is based on gross square footage). 5. Sampling Or Modeling Approach The sampling or modeling approach uses a created model (or template) to analyze multiple facilities that are nearly identical in construction, appearance and use (e.g., fast food chains and retail outlets). The use of sampling minimizes resources and costs compared to conducting studies on all properties. A frequent issue is the accuracy of the sampling results. In some cases, the sampling method may not be statistically valid. In addition, a population less than 50 could limit the accuracy of a sampling technique, unless an appropriate sampling error is considered. Also, despite the fact that facilities within certain strata may appear to be very similar, variations in building codes, geographic location, and material and labor costs may make it difficult to determine an appropriate model. 6. "Rule Of Thumb" Approach Some cost segregation studies are merely based on a "rule of thumb" approach. In general, this approach uses little or no documentation and is based on a preparer's "experience" in a particular industry. For example, a preparer will estimate § 1245 property as a fixed percentage of project cost by relying on previously determined "industry averages" (e.g., 40% for a manufacturing facility). An examiner should view this approach with caution, since it lacks sufficient documentation to support its allocation of project costs. WHAT METHODOLOGY IS REQUIRED BY THE IRS? Neither the Service nor any group or association of practitioners has established any requirements or standards for the preparation of cost segregation studies. The courts have addressed component depreciation, but have not specifically addressed the methodologies of cost segregation studies. The Service has addressed this issue but only briefly, i.e., Revenue Ruling 73-410, 1973-2 C.B. 53, Private Letter Ruling (PLR) 7941002 (June 25, 1979), Chief Counsel Advice Memorandum 199921045 (April 1 ,1999). These documents all emphasize that the determination of § 1245 property is factually intensive and must be supported by corroborating evidence. In addition, an underlying assumption is that the study is performed by "qualified" individuals or firms, such as those employing " ... personnel competent in design, construction, auditing, and estimating procedures relating to building construction" (PLR 7941002). Despite the lack of specific requirements for preparing cost segregation studies, taxpayers still must substantiate their depreciation deductions and classifications of property. Substantiation using actual costs is generally preferable to the use of estimates. However, in situations where and the source of any cost data should be clearly documented. In addition, estimated costs should be reconciled back to actual costs or purchase price. SUMMARY AND CONCLUSIONS Cost segregation studies are prepared for a variety of reasons (e.g., income tax, financial accounting, insurance purposes, property tax), and many different methodologies and procedures are used. While neither the Service nor any group or association of practitioners prescribes a specific methodology, there are certain approaches (e.g., studies based on actual costs or on proper estimation techniques) that produce more accurate and reliable allocations. Despite the use of one of these more reliable methods, issues may still arise with respect to the proper classification of § 1245 property. Methodologies that yield accurate cost allocations expedite the Service's review, saving time and resources for taxpayers, practitioners, and Service examiners alike. A study that is both accurate and well documented is considered a "quality" cost segregation study.
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